[TheOptionClub.com] Re: Money Management

 

@Migo1

It would be a lot kinder for the other readers to provide an explanation for the formula rather than suggest a mediocre education as a result of not understanding it. I don't understand the formula you have presented but this fact is yet to hinder my trading.

The common way to calculate expectancy is as follows:

Expectancy = (Probability of Win * Average Win) - (Probability of Loss * Average Loss)

There are two big problems with trying to calculate expectancy however:

1. Statistics for the formula

Statistics to calculate expectancy must be taken from only one strategy at a time and the strategy must have clearly defined rules. Most people trade several different options and stock strategies in their account making it difficult to separate them out. Furthermore very few people have clearly defined rules for their trading strategies and those that do usually lack the emotional intelligence to adhere to those rules making the statistics irrelevant.

2. Market action does not fit into a bell curve

Even with a long track record or success in back testing through extreme market conditions the market has a tendency to break the mold far more often that would be reasonably expected. Many Quant funds discovered this the hard way in 2007 during the subprime meltdown. Prices began to ‘misbehave’ and events that models predicted would happen once in 10,000 years happened every day for three days. Despite having a 'positive expectancy' many Quants were brought to their knees.

There are options strategies that have a high probability profit but on rare occasions suffer big losses that can claim back several years of profits. Unfortunately these rare occasions tend to be uncomfortably frequent.

The most important consideration when it comes to money management in my opinion is to ensure that you have the ability to endure a STRING of 'Worst-Case-Scenario' trades and still recover your account.

Cheers
Derry
http://etfhq.com/

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